Gordon Brown has issued a public threat to Iceland, demanding the return of up to £20 billion belonging to British savers, companies and local councils.

The Prime Minister said Britain would seize the assets of Icelandic companies and take “further action against the authorities” over the collapse of the island’s banks.

The diplomatic row, which has echoes of the Cod Wars of the 1970s, erupted after it emerged that more than 100 local authorities have deposits in Iceland. They stand to lose a total of more than £1 billion. British companies are said to have as much as £12 billion in the failed banks and individual savers more than £6 billion.

Unless the Icelandic government agrees to return the cash, British taxpayers will have to foot the bill to bail out local councils and other public bodies. This would come through increases in council tax or Treasury funds. It would mean the Government spending more public money because of the financial crisis after staking £500 billion in an attempt to rescue British banks.

Yesterday there were few signs that Mr Brown’s bail-out gamble was paying off. Bank shares rose but the FTSE-100 closed 1.2 per cent down. There was little evidence that banks were more prepared to lend to each other and no British bank has requested any of the £50 billion available.

Mr Brown said the behaviour of the Icelandic government in failing to guarantee the return of British money was “unacceptable”. He vowed to go beyond the action already taken against Landsbanki, one of the Icelandic banks which had its UK assets seized on Wednesday under anti-terrorism laws meant to stop extremist groups laundering money.

Mr Brown told the BBC: “We are freezing the assets of Icelandic companies in the UK where we can. We will take further action against the Icelandic authorities wherever that is necessary to recover the money.”

He has also called on the rest of the world to follow Britain’s “ground-breaking” move to save the banking system. Mr Brown urged other governments to put money into struggling banks and offer similar guarantees to persuade them to resume lending to each other.

Icelandic investment companies own several high street chains including Debenhams, Whistles and Oasis as well as the Premier League football club West Ham United. A war of words started as Geir Haarde, the prime minister of Iceland, used a press conference to denounce the seizure of Landsbanki assets. The use of anti-terrorism legislation was “not pleasant”, he said.

The Treasury has guaranteed the deposits of the estimated 300,000 private British investors in the collapsed banks Landsbanki, Glitnir and Kaupthing, which have been put in government administration.

But ministers say they cannot give the same assurance to wholesale investors, including councils and companies. The Daily Telegraph has established that at least 111 public bodies have £944.07 million deposited in Icelandic banks. That includes 15 police authorities, which invested £95.72 million, and transport authorities including Transport for London, which deposited £40 million alone.

The remaining bodies were local councils. Kent county council was the biggest investor, with £50 million — £59.76 per taxpayer in the county – at stake. The London borough of Haringey deposited £37 million, equal to £324.14 per taxpayer.

The Local Government Association insisted that the sums remained a small proportion of councils’ total funds and said no front-line services would be cut. Ministers promised emergency help for councils “facing severe short-term difficulties”. A team of Treasury officials may go to Reykjavik as soon as today to discuss an agreement with Iceland.